AAR Corp. (NYSE:AIR) Q2 2024 Earnings Call Transcript

AAR Corp. (NYSE:AIR) Q2 2024 Earnings Call Transcript December 21, 2023

AAR Corp. reports earnings inline with expectations. Reported EPS is $0.81 EPS, expectations were $0.81. AIR isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good afternoon, everyone. Welcome to AAR’s Fiscal 2024 Second Quarter Earnings Call. We are joined today by John Holmes, Chairman, President and Chief Executive Officer; and Sean Gillen, Chief Financial Officer. Before we begin, I’d like to remind you that comments made during the call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. Accordingly, these statements are no guarantees of future performance. These risks and uncertainties are discussed in the company’s earnings release and the Risk Factors section of the company’s annual report on Form 10-K for the fiscal year ended May 31, 2023 and Form 10-Q for the fiscal quarter ended August 31, 2023.

In providing the forward-looking statements, the company assumes no obligation to provide updates to reflect future circumstances or anticipated or unanticipated events. Certain non-GAAP financial information will be discussed on the call today. A reconciliation of these non-GAAP measures to the most comparable GAAP measures are set forth in the company’s earnings release. A replay of this conference call will be available for on-demand listening shortly after the completion of the call on AAR’s website. At this time, I would like to turn the call over to AAR’s Chairman, President and CEO, John Holmes.

John Holmes: Great. Thank you, and good afternoon, everyone. I appreciate you joining us today to discuss our second quarter fiscal year 2024 results. Before we discuss these results, I wanted to comment on the acquisition agreement that we announced this morning. For many years, we have been focused on growing our position in the market for proprietary and differentiated services and we have long viewed Triumph’s Product Support group as one of the leaders in this market for repair. In fact, in the more than 5 years since I became CEO, I’ve had a number of conversations with Triumph’s CEO about the possibility of AAR acquiring this business. So similar to our Trax acquisition that we announced earlier this year, this is an idea that we have had for a long time, and I’m very excited that we’ve reached an agreement with Triumph.

We believe that the acquisition will bring scale to our existing component repair operation, add next-generation repair capability, deepen and broaden our customer relationships globally and expand our footprint. The quality of this business is reflected in its margins, which we anticipate will meaningfully enhance our own margin profile. We expect numerous benefits associated with integrating our existing Part Supply, repair and engineering and integrated solutions volumes with this business’s operations. Triumph Product Support also comes with a large DER portfolio and significant PMA development capabilities. We expect this will accelerate our growth in each of these areas. Additionally, its Thailand facility will help AAR further penetrate the high-growth Asian market.

Finally, this business comes with a talented and accomplished leadership team. Overall, we expect this acquisition, which fits squarely into our stated strategy to be highly value accretive and it adds significant scale, differentiated capability operating margins of approximately 18%, a strong cash flow profile and significant synergy opportunities. Turning to the results. We delivered another strong quarter of financial and operational performance, which resulted in record adjusted second quarter earnings. Specifically, sales for the quarter were up 16% year-over-year from $470 million to $545 million. Sales to commercial customers increased 24% and sales to government customers increased 1%. Within Parts Supply, sales were up 24% over the prior year quarter driven by strong customer demand for used service and material and continued expansion of our commercial distribution activities.

Regarding USM, our global sourcing team continues to secure material that is in high demand. Much of this material requires repair work before it is resold and we continue to navigate extended turn times with our partner repair vendors. New parts distribution saw continued growth in both our existing and new commercial product lines, which more than offset continued slower parts sales to the U.S. government. On that note, we have started to see a slight increase in our parts booking with the government which is encouraging. In repair and engineering, sales were up 8% over the prior year quarter driven by strong performance across our hangars and component repair operations. In Integrated Solutions, sales were up 23% over the prior year quarter due to increased flight hours in our power-by-the-hour programs and strong performance across our government programs.

Trax also contributed to sales growth this quarter, and that integration continues to go well. On that note, Trax has a growing pipeline of opportunities as the value proposition of combining Trax’s industry-leading software with AAR scale and financial support as resonating with customers across the boat. In expeditionary Services sales were down 34% over the prior year quarter due to a significant decline in mobility shipments of pallets to the Department of Defense. As a reminder, Mobility’s products are used in support of U.S. troop movement which has not increased in the current environment. The decline in sales activities is the result of funding being diverted to the effort in Ukraine, and we expect this to return to more normalized levels towards the end of our fiscal year.

Turning to profitability. Our adjusted operating margin was 8.1%, up from 7.6% in the prior year quarter. Operating margins expanded in parts supply and repair and engineering. Trax also contributed to our overall margin expansion. Further, this represents our 11th straight quarter of year-over-year adjusted operating margin improvement. Our operating – our adjusted diluted earnings per share from continuing operations were up 17% from $0.69 per share second quarter last year, to a record of $0.81 per share this year. With respect to cash, we generated $17 million in cash flow provided by operating activities from continuing operations in the quarter. We continue to see attractive opportunities to invest in our Parts Supply segment, which resulted in net inventory increasing $32 million during the quarter.

We expect these investments to continue to drive growth for both USM and distribution. Our cash flow and continued EBITDA growth resulted in leverage at the quarter end of only 1.0x adjusted EBITDA, and as such, our balance sheet remains exceptionally strong, which helped enable the agreement to acquire Triumph’s Product Support business. Turning to new business. We had several wins announced during the quarter and subsequent to the quarter. These wins across multiple business segments inside of AAR and demonstrate the strength of our offering to customers. In repair and engineering, we announced an extension and expansion of our airframe services agreement with Alaska Airlines, including the planned corresponding expansion of our hangar capacity at Will Rogers World Airport in Oklahoma City.

Similar to our previously announced expansion in Miami, this product meets all of the criteria that we have outlined for MRO capacity growth, which includes a supportive relationship with the airport and local government, favorable labor market dynamics and a long-term customer commitment. We are excited about this opportunity and would like to thank Alaska Airlines, Oklahoma City Airport Trust and all those who made this possible. In Parts Supply, we announced a multiyear contract extension with MTU Maintenance to supply USM parts for Pratt & Whitney 2000 engines. And also, we announced a new multiyear distribution agreement to supply Woodward’s fuel control products to the Defense Logistics Agency under our captains of industry contract.

Finally, in Integrated Solutions, Airinmar announced a new multiyear services agreement with Turkish-based low-cost carrier, Pegasus Airlines, for warranty support services. With that, I’ll turn it over to our CFO, Sean Gillen, to discuss the results in more detail.

Sean Gillen: Thanks, John. Our sales in the quarter of $545.4 million were up 16.1% year-over-year. Our commercial sales were up 23.5%, driven by growth across most of those operations, particularly Parts Supply, and our government sales were up 1.4% due primarily to integrated solutions, partially offset by declines for new parts distribution and Parts Supply and Expeditionary. Gross profit margin in the quarter was 19%, up from 18.3% in the prior year quarter on a reported basis, and up from 18.8% in the prior year quarter on an adjusted basis. Overall margin performance was strong across our activities, with notable improvement in commercial programs as well as the contribution from Trax. Gross profit margin in our commercial business was 20.4%, and gross profit margin in our government business was 15.4%, which reflects the softer performance in mobility that John mentioned.

SG&A expenses in the quarter were $65.7 million, which included $3.1 million from acquisition and amortization expenses and $2.6 million of investigation costs. Excluding these items, SG&A was $60 million or 11% of sales. Net interest expense for the quarter was $5.5 million compared to $1.5 million last year, driven by higher interest rates and borrowings. Cash flow provided in operating activities from continuing operations was $17.4 million. In addition to generating cash, we continue to invest in the business as evidenced by the $32 million increase in inventories. Our balance sheet remains exceptionally strong with net leverage at 1x adjusted EBITDA, which enables us to make both organic and inorganic investments, namely our announced acquisition of Triumph Product Support.

On that note, with respect to the planned acquisition, as indicated in the release and the slides that we posted to our website, the consideration is $725 million. We expect to receive tax benefits with a present value of approximately $80 million as part of the transaction. Net of this tax benefit, the purchase price is $645 million which represents a multiple of 11.7x EBITDA for the fiscal year ending March 2024, and 9.9x EBITDA inclusive of the $10 million of run-rate synergies. Funding for the acquisition is supported by a fully committed bridge facility. The closing of the acquisition is subject to regulatory clearance and other customary closing conditions, and we plan to conduct a permanent financing in conjunction with the closing that will include debt and subject to market conditions, equity.

Inclusive of an equity issuance, our target net leverage at closing is approximately 3x. We expect to begin to realize synergies shortly after closing and to fully realize the run rate synergies by the end of our fiscal year 2026. Given the growth in cash flow outlook of both the target and AAR, we expect to further de-lever post close. The transaction is expected to be accretive to our adjusted earnings per share for our full year fiscal 2025. Note that consistent with current practice, our adjusted earnings per share and adjusted operating earnings will not include non-cash amortization and similar expense associated with purchase accounting, which we anticipate to be approximately $20 million to $25 million per year. Thank you for your attention, and I will now turn the call back over to John.

John Holmes: Great. Thank you, Sean. I am pleased that we delivered another strong quarter of year-over-year revenue growth and adjusted operating margin expansion. The macro environment for the commercial aviation aftermarket continues to be very strong, and our customers have signaled strong demand for our services in calendar 2024. Furthermore, continued new aircraft delivery constraints and issues related to newer generation engines are expected to drive increased demand for mid to late life aircraft, which, as you know, is a core market for AAR. For our parts activities, we expect continued growth in both USM and new parts distribution. We expect to invest in both USM material as well as in new business wins in distribution and expect these investments will drive our results going forward.

In repair and engineering, our hangars are operating at near capacity and we expect that to continue for the foreseeable future. We are excited about the planned expansions at both our Miami and Oklahoma City facilities. In Integrated Solutions, our Trax acquisition is performing well and positively contributed to our financial results. Our portfolio of government programs is stable, and we believe we have a strong pipeline of opportunities with the Department of Defense and other government customers. As we turn to calendar year 2024, we are focused on converting this pipeline to new business wins. Looking forward with respect to Q3, overall, we expect continued year-over-year sales and earnings growth. Specifically, we expect high single-digit to 10% year-over-year sales growth, and adjusted operating margins to be consistent with the quarter that we just delivered.

This does not assume any impact from the Product Support acquisition announcement. I am incredibly proud of the work our team continues to do to produce the record results that we have achieved. The favorable macro environment and our ability to execute continues to be a powerful combination. Further, the acquisition of Triumph Product Support meaningfully accelerates our strategy to add differentiated, complementary, high-margin capability to our overall aviation services offerings, and we cannot be more excited to welcome Triumph Product Support’s talented team to AAR. With that, I’ll turn it over to the operator for questions.

Operator: Thank you. [Operator Instructions] And our first question will come from the line of Robert Spingarn with Melius Research. Your line is open.

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Q&A Session

Robert Spingarn: Thank you. Hey, guys. Congratulations on the deal.

John Holmes: Thanks very much, Rob.

Robert Spingarn: I’d like to ask maybe a multipart question on that, and then I have a question on the business. But let’s start with the top line. You mentioned, I think, that the deal should be accretive to sales growth, but which sales growth target? Is that next 12 months? Is that your long-term target you talked about in July? How do we think about that?

Sean Gillen: Yes. I think – we think it will be accretive to sales growth as – after we closed the deal and it contributes, and I think that 5% to 10% that we’ve talked about long-term, I think it’s accretive to that as well and we’re push higher to the – higher end of that range.

Robert Spingarn: Okay. Okay. And then I know, John, I think you talked about synergies, I just wanted to – and you ran through a bunch. But high level, if you could detail that a little bit on the cost side and then as well on the revenue side, revenue synergies.

John Holmes: Yes, sure. The $10 million that we cited is all cost. And that’s – we expect that to come from multiple areas, and we feel very, very confident in that number. Now with our two existing repair sites in New York and Amsterdam as well as the five sites that we’re taking on in – with Triumph, we’ve got a fair bit of opportunity to rationalize capability amongst all of those sites. And that will drive some – a good chunk of the cost synergy. Additionally, there is actually quite a lot of repair work that we send out in support of our power-by-the-hour program. That could go to Triumph, but today goes to other vendors. And so we would expect to consolidate that work ultimately based on the new capability that we’re acquiring.

So those would be the two major building blocks of the cost synergies. At this point, we have not, in that number of $10 million, factored into any revenue synergies, but you can expect that we believe that there is quite a lot of opportunity to cross-sell amongst customers where Triumph is strong and we’re not, and conversely, customers where AR is strong and Triumph is not.

Robert Spingarn: Is it fair to think of this as a good platform for your parts. You can insert those in the Triumph facilities?

John Holmes: Yes. I think, yes, with an outlet there, the other synergy between the repair business and the parts business is we have to support the trading business, we have a fairly large rotable pool both of actual rotable components, but then also structural components. Those components are synergistic with repair businesses because they also augment turnaround times that provide exchange units and extraction units. And so the trading business and the repair business have synergies that way as well.

Robert Spingarn: Okay. And then last one on this, Sean, for you. Thinking about the potential equity issuance versus just debt financing, the entire thing. It seems like the accretion is pretty similar, but the equity dilution would be more long-term, let’s say, unless you bought back the stock. So what’s the calculus behind that especially given your balance sheet?

Sean Gillen: Yes. So, the balance sheet is – actually puts us in a good spot. And I think the way we think about that is targeting 3x at close, which would be inclusive of an equity issuance. If you didn’t have an equity issuance, you’d probably be closer to 3.6, 3.7. And the thought there is just continuing to be more conservative on the balance sheet and continue to allow for investments to help drive growth across the other businesses as well, so evaluating equity alongside the debt.

Robert Spingarn: Got it. Okay. John, last one. It’s on the business. Last time, you talked a little bit about some headwinds having the end of – or coming from the end of a landing year overhaul cycle. And just wondering, do you have any more of those coming up either in the core business or at Triumph, where you either have a headwind because an overall, a certain component cycle is ending or you have a tailwind because one is starting.

John Holmes: Sitting here, not that I can think of. I mean, landing gear out of all the repair businesses, both heavy maintenance as well as all of the businesses that Triumph is involved in is the most cyclical. So that would be – that would really be situational to landing gear versus our other MRO operations and certainly the operations in Triumph’s portfolio.

Robert Spingarn: Okay, thanks so much.

John Holmes: Thanks, Rob.

Operator: Thank you. [Operator Instructions] And that will come from the line of Bert Subin with Stifel. Your line is open.

Bert Subin: Hey, good afternoon. Appreciate the question.

John Holmes: Hey, thanks for joining us. You picked the good time.

Bert Subin: Yes. I know. Yes, that’s right. Maybe, John, just to start sort of high level on the Triumph side, can you just provide us some context on what this acquisition does for you that you think would have been too difficult to do organically? And I guess the reason I’m asking is like, how do you think about what this brings to overall AAR and why this sort of speeds up the process of growth?

John Holmes: Yes, great question. Just a few thoughts there. First of all, I want to highlight that this was a negotiated transaction. This was not a process. The CEO of Triumph, Dan Crowley and I, worked together on the – and that came out of the fact that for several years, as I mentioned at the beginning, we have felt that this business would be highly complementary and strategic to AAR’s offering. So we were very pleased that the stars aligned and we were able to reach agreement with Triumph. What it brings to us is a number of things. As I mentioned, there are synergies around just straight cost and that will come from footprint rationalization across the combined seven facilities as well as in-sourcing quite a lot of work that AAR sends out today in support of our flight hour programs.